2020 4Q Market and Economic Outlook
The year 2020 was a wild ride and the last three months capped the year appropriately. Many were happy for a turn of the calendar, but so far 2021 has had more of the same. Politics dominated the quarter, as we witnessed a disputed election that took various twists and turned and left the country even more divided. Had an investor known in advance exactly what would happen, it probably would not have helped to get better investment returns. I wrote in the last update that a disputed election that causes people to lose faith in the system is probably the worst outcome. We got that. A split government is generally considered good by the markets because it is more stable. It appeared we would get that, but that did not happen either. The new administration is less business-friendly than the old. None of this has mattered. Stocks staged an impressive rally in the final quarter, with the S&P 500 returning 12.1%, and the S&P 600 31.2%. Fourth quarter GDP growth remained strong, coming in at 4% annualized quarter over quarter growth, exactly in line with estimates. Coming off of the massive COVID disruptions there is an element of getting back to normal that is transitory, so all economic readings should be taken with a grain of salt. Further, per capita GDP is still lower than it was a year ago.
More important than where we have been is where we are going from here. Many believe there is significant pent-up demand among consumers, who are eager to use the money they have been unable to spend. Certainly, there is merit to this – who isn’t eager to travel, go out to eat or go to an entertainment event? Economist David Rosenberg takes issue with this argument for an especially robust economy, as the segments that have been most affected – travel, dining and personal services – are a small part of the overall economy. Most of that demand perishes. A person may long for a manicure, or a meal out, but nobody will get twelve manicures or order multiple meals to catch up for a year of missing out. Further, behavior has changed as people became more self-reliant and learned to cook and do other things for themselves. He further argues that stimulus money and cheap credit have led people to overspend on big purchases such as cars and home improvement, such that the appetite for these may be satiated. There is also the issue of what economists call “scarring” – permanent damage caused by short-term traumatic events. This is most evident in all the small businesses that have closed and will no longer be around to participate in any sort of recovery. This is an interesting debate, and both sides have merit. I see a slow recovery where it takes a couple of years to get back to where we were before the pandemic.
While political and economic trends matter, they are always changing. The price paid for an investment today discounts all earnings from that investment into perpetuity. Price paid is the most important factor for determining investment return. Last quarter, I shared a chart from Advisor Perspectives showing the S&P 500 at very high levels according to four long-term valuation methods. This chart bears repeating as the fourth quarter saw a significant expansion of valuations. What I find striking is that the rapid bear market last March still left stocks at among the richest valuations over the last twelve decades. The spike up off that (not) low level over the last several months has few historical corollaries.
Other measures show similar overvaluation. The trailing Price/Earnings (P/E) ratio of 37.6 at the beginning of this year is 91% higher than the fifty-year average. The Price/Sales (P/S) is 80% higher than the average since 2000, which has been a period of abnormally high valuations to start with.
John Mauldin notes that the expansion in stock market valuations has coincided with an explosion of moneyar stimulus. The US Federal Reserve alone has increased its asset base (i.e. created new money) from a little over $4T at the start of the recession to over $7T by the end of 2020. Other major Central Banks have followed suit, adding over $7T of liquidity into the world. He also shows that on fifteen different valuation metrics, the current environment (mid-December) is at 100th percentile on eleven metrics and 91st or higher on the others. While temporarily depressed earnings would skew some of these metrics somewhat, others are based on book value or longer-term metrics.
When assets are priced on underlying fundamentals, one can simply focus on those fundamentals. This is my natural bent, and when I see a divergence from normal fundamental valuations, I like to position myself to benefit from a reversion to the mean. The problem, which we have witnessed over the last several years, is that non-fundamental factors can cause trends to persist for quite some time. In these cases, sentiment becomes important, at least for predicting short-term outcomes. Sentiment can become self-reinforcing. Those who doubt a raging bull market sit on the sidelines and watch their friends and neighbors make money. Slowly, new people are enticed to join the game until finally no one is left to join, and thus no new money to bid prices even higher. At that point, some who dreamed of fast gains and easy riches get disillusioned and sell, but with no incremental buyers the process unwinds. The most dangerous point is the that of maximum optimism. This also works in reverse. This is the paradox of markets. The worst time is when things look the best and the most opportune time is when things look the worst. This raises a relevant question for today. Who is left to buy? Lance Roberts calls attention to the extremely bullish positioning of retail investors, as well as record low levels of cash holding by pension funds and mutual funds. Meanwhile, small trader purchases of call options (a leveraged and highly aggressive bullish bet) have rarely topped $5B, but recently spiked to $44.4B. It seems the only group doubting current stock prices are the people who run publicly traded companies. Insider buying spiked last March, but now is at extreme low levels. The level of margin debt has increased rapidly and is now at all-time highs. This shows how aggressive investors are by borrowing to invest.
Strength in the market is no longer widespread, but is focused in certain narrow areas. Stocks that have performed the best in recent months are those with no earnings and those that are most heavily shorted. Roberts cites a Goldman Sachs chart showing the fifty most heavily shorted stocks have returned over 250% in the last few months. Jesse Felder shows the number of S&P 500 components trading at greater than ten times sales has recently spiked to all-time highs. Divergence of performance is often viewed as a sign that market strength is beginning to wane, but it also means there are opportunities outside of the popular areas. Another sign of an extended market is a rush to access capital markets. Not only have IPOs risen, but direct listings and SPACs are taking off. Businesses see this as an attractive market in which to sell equity.
I admit to favoring the writers who currently hold bearish opinions, but this is because their arguments make more sense to me right now. Any argument has two sides, and most people do believe in the current market valuations, or they would not exist. Any investor should know where he could be wrong, so I have sought out the other side. I found two main themes. First, is that we are in a new world, such that history is irrelevant. Old industries are being disrupted, new ones created, and an age of tech-induced prosperity is just starting to arrive. Companies no longer need capital to create massive wealth (think Google, Facebook, and all the cloud-based companies.) Even individuals can create their own social media empires, gaining great wealth quickly. A similar argument is that valuations are permanently higher due to Central Bank stimulus or other reasons. Some would even argue that fundamentals no longer matter. I believe those who wish to dismiss history should first study it. Economy-changing technological innovations have been occurring for at least 140 years. Wealth and living standards have certainly improved, and the world today would not be recognizable by our nineteenth century forebears. This has contributed to very solid equity returns. It could also be that multiples should be higher than in the past, but current multiples are very high even by the standards of the last two decades. The second theme is that the same factors that have pushed valuations for nearly everything to high levels will continue unabated for some time. Fiscal and monetary stimulus will continue to grow, pumping the economy and the speculative frenzy. This could be, but it only pushes the eventual reckoning a little further down the road.
What is an investor to do? One could hold cash and lose value to inflation, or hold an inflation hedge such as gold and just wait. One could invest and ride out the waves and any potential economic storm, knowing that eventually investments should generate a positive return. Or one could systematically try to manage risk to avoid most of the large moves down while looking for relatively attractive asset classes in which to invest. This is like a sailor tacking with the wind and avoiding the worst of the waves.
The problem with waiting for a better opportunity is it is hard to know when it exists. Stocks have been expensive historically for several years, yet intrepid investors have done quite well. Even recent sell-offs never reached bargain levels. One could have missed the last twenty-five years. Simply buying and holding can work for people with long-term horizons. An investor contributing monthly gets to purchase lower after a market crash and wait for a recovery. The problem is people at or near retirement may not have a decade to wait for asset values to return to their starting level. They are relying on annual returns from their portfolios. Eric Basmajian demonstrates that simply extending your holding period for ten years is no guarantee of returns anywhere near average. S&P 500 ten year holding period returns have ranged from -6% to +20% when adjusting for inflation. In financial planner parlance, this is major sequence of return risk. Our current valuation starting point has historically yielded real returns of -3.9% - 4.4%. GMO now projects negative seven-year real (inflation-adjusted) returns in most asset classes, including -5.8% for US Large Cap, and -3.4% for US bonds. If this is right, a passive investor with 60% exposure to the S&P 500 and 40% to the bond index will lose 29% of his portfolio value in the next seven years – if he doesn’t pay taxes or fees, and doesn’t panic after a crash and miss the recovery. Similarly, Dr. John Hussman predicts a -2.15% annual nominal (including inflation) return for a 60/30/10 portfolio over twelve years. If these estimates are anywhere close to being right, planning to ride out the storm is a dangerous proposition.
Jeremy Grantham is one of the world’s foremost bubble expert. While he has been bearish on this market for some time, he resisted using the “bubble” label. Until now. “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.” He further warns: “But this bubble will burst in due time, no matter how hard the Fed tries to support it, with consequent damaging effects on the economy and on portfolios. Make no mistake – for the majority of investors today, this could very well be the most important event of your investing lives.”
The third option is seek out relatively better priced opportunities, invest cautiously and manage risk closely. This is harder than it sounds, but there are still opportunities. I have spent much of the last year seeking out reasonable places to invest, as well as ways to systematically manage risk to try to avoid major drawdowns. The markets rarely move in straight lines, and returns over a business cycle are made up of smaller moves up and down. While no system is fool-proof, having a plan in place and systems to employ beats reacting under duress. To learn more about how I am positioning clients in this market, reach out to me directly.
Basmajian, E. (2020, December 22). SPY: 100 Years Of Data Says Buy & Hold Will Fail You. Retrieved from Seeking Alpha: https://seekingalpha.com/article/4395727-spy-100-years-of-data-says-buy-hold-will-fail-you?utm_medium=email&utm_source=seeking_alpha&mail_subject=spy-100-years-of-data-says-buy-hold-will-fail-you&utm_campaign=nl-etf-daily&utm_content=link-0
Felder, J. (2021, January 6). "What Were You Thinking" Part Tres. Retrieved from The Felder Report: https://thefelderreport.com/2021/01/06/what-were-you-thinking-part-tres/
Fox, M. (2020, December 18). Markets Insideer. Retrieved from Business Insider: https://markets.businessinsider.com/news/stocks/spacs-raised-73-billion-more-than-traditional-ipos-blank-checks-2020-12-1029906693
GMO Asset Allocation Team. (2020, December 22). https://www.advisorperspectives.com/commentaries/2020/12/22/gmo-7-year-asset-class-forecast-november-2020?bt_ee=VTD0CfTtvSpqHhur0K8c%2F63lh3Ia4sXjqccDNaou7RrEm83bCQgAojX2MXn6u6%2BG&bt_ts=1608669127385. Retrieved from Advisor Perspectives: https://www.advisorperspectives.com/commentaries/2020/12/22/gmo-7-year-asset-class-forecast-november-2020?bt_ee=VTD0CfTtvSpqHhur0K8c%2F63lh3Ia4sXjqccDNaou7RrEm83bCQgAojX2MXn6u6%2BG&bt_ts=1608669127385
Grantham, J. (2021, January 5). Waiting for the Last Dance. Retrieved from Advisor Perspectives: https://www.advisorperspectives.com/commentaries/2021/01/05/waiting-for-the-last-dance?textlink&bt_ee=s0IomJaCLUSMGO3V1iw89i50HkVA01Ku5C4gUnz5Tfmin9UEHUQqFaSpyZoLEWrH&bt_ts=1611743723261
Hulbert, M. (2020, January 26). Opinion: Insider selling is alarmingly high and small-cap stocks are in the crosshairs. Retrieved from MarketWatch.com: https://www.marketwatch.com/story/insider-selling-is-alarmingly-high-and-small-cap-stocks-are-in-the-crosshairs-11611624945?mc_cid=83e80e9c18&mc_eid=b65c6f46b3
Hussman, J. (2021, February 1). Detached Parabolas and Open Trap Doors. Retrieved from Advisor Perspectives: https://www.advisorperspectives.com/commentaries/2021/02/01/detached-parabolas-and-open-trap-doors?bt_ee=IdUDNdlsblFPu7uGGpUA180gfSQguPnnvrv6YPUVo01Ym34cNnYKG00dMOgSBE%2Fv&bt_ts=1612211635056
Mauldin, J. (2020, December 18). Stock Market Party. Retrieved from Advisor Perspectives: https://www.advisorperspectives.com/commentaries/2020/12/18/stock-market-party?bt_ee=xwm6U%2BSrdt7indklxD0hRkBJxJokJ1m2Q75wyJ8nBPEU%2FEyiRVNbALdeAmNYQqvi&bt_ts=1608335720247
Mislinksi, J. (2021, January 22). Margin Debt and the Market: Up 7.7% in December, Another Record High. Retrieved from Advisor Perspectives: https://www.advisorperspectives.com/dshort/updates/2021/01/22/margin-debt-and-the-market-up-7-7-in-december-another-record-high
MIslinski, J. (2021, January 28). Q4 GDP Advance Estimate: Real GDP at 4%. Retrieved from advisorperspectives.com/dshort: https://www.advisorperspectives.com/dshort/updates/2021/01/28/q4-gdp-advance-estimate-real-gdp-at-4
Roberts, L. (2020, February 5). Market Review: Bull Mania And The Charge Of The Light Brigade. Retrieved from Seeking Alpha: https://seekingalpha.com/article/4403796-market-review-bull-mania-and-charge-of-light-brigade?mail_subject=lance-roberts-market-review-bull-mania-and-the-charge-of-the-light-brigade&utm_campaign=rta-author-article&utm_content=link-1&utm_medium=email&utm_s
Rosenberg, D. (2021, January 28). Super Terific Happy Hour Ep. 9 - David Rosenberg: I've Never Met a Rude Canadian. (G. W. Pomboy, Interviewer)
The views expressed are the views of Jacob Rothman on behalf of Rothman Investment Management, LLC through the period ending December 31, 2020 unless otherwise specifically indicated and are subject to change at any time based on market and other conditions. No client or prospective client should assume that any such discussion serves as a substitute for personalized advice from Rothman Investment Management, LLC.
The information herein should not be considered a recommendation to purchase or sell any particular security. The securities and strategies discussed herein are meant to be examples of Rothman Investment Management investment approach but do not represent an entire portfolio or the performance of a Fund or Strategy and in aggregate may only represent only a small percentage of the portfolio holdings. It should not be assumed that any of the securities discussed herein were or will prove to be profitable, or that the investment recommendations or decisions made by Rothman Investment Management in the future will be profitable. Further, nothing in this letter should be taken as financial advice.
The benchmark for US Large Capitalization stocks is the S&P 500, a market capitalization weighted index containing the 500 most widely held companies.
Past performance is not indicative of future results. Therefore, no current or prospective client should assume that future performance of any specific investment, investment strategy or product made reference to directly or indirectly in this letter or indirectly via a link to an unaffiliated third party web site, will be profitable or equal the corresponding indicated performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or prospective client’s investment portfolio. Historical results for investment indices and/or categories generally may not reflect the deduction of transaction and/or custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical results.
 Data from finance.yahoo.com. I am using SPY and SLY as the proxies for the S&P 500 and S&P 600, respectively.
 (MIslinski, 2021)
 As Rosenberg put it, increased demand for crock pots and cook books will lead to lower demand for restaurants.
 (Rosenberg, 2021)
 Ratios calculated from data available at multpl.com, and are based on the S&P 500
 (Mauldin, 2020)
 “Record” over the duration of the data set, which goes back to 1965. There may have been lower levels before this. These numbers matter because pension funds and mutual funds hold a large percentage of the overall investment markets, and have some discretion on how aggressive to be. When cash levels are high, so is potential investment, which could boost asset prices. Relative to historic levels, these are already fully invested.
 (Roberts, 2020)
 (Hulbert, 2020)
 (Mislinksi, 2021)
 (Hussman, 2021)
 In general, heavily shorted stocks are troubled companies, and their prices underperform. That these are not only the best performing stocks, but have realized hundreds of percentage points of gains suggests a speculative mania.
 (Felder, 2021)
 (Fox, 2020)
 Gold is a commonly used store of value to avoid the depreciation of currency, but because of the noise in gold price, it only works well over long periods of time.
 (Basmajian, 2020)
 (Basmajian, 2020)
 (GMO Asset Allocation Team, 2020)
 (Hussman, 2021)